Liquidity Effects, Models of

Abstract

An exogenous increase in the money supply is typically followed by a temporary fall in nominal interest rates. Flexible price macroeconomic models argue that this liquidity effect arises because asset markets are segmented. That is, only a fraction of the agents are present in the bond market when the central bank conducts an open market operation. However, to be quantitatively successful, segmented markets models assume frictions that are too large to be interpreted literally in terms of constraints faced by real-world firms and households. An important open question is: can a complicated array of microeconomic frictions imply one large aggregate friction of this kind?

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